Rates Tantrum Pulls ‘Year-End’ Forward By 51 Weeks

One amusing — if somewhat trite — takeaway from last week’s fireworks in the bond market was the observation that 10-year US yields could reach some analysts’ year-end targets just a few weeks into the new calendar.

Of course, forecasting yields 12 months hence isn’t an endeavor that’s conducive to success. As Morgan Stanley’s Matthew Hornbach put it in February of 2018, “history has shown consensus estimates for Treasury yields are usually wrong [and] everyone understands that accurate point forecasts rarely occur.”

“Sellside strategists’ year-ahead forecasts without fail predict a rise in both equity markets and bond yields,” SocGen’s Albert Edwards wrote, at the end of 2019, calling analysts’ predisposition to predicting higher stocks and bond yields “the symptoms of a congenital condition so deeply ingrained it will never change.”

To be fair, the upside bias on equity targets could be in part a reflection of the fact that, over time, stocks tend to rise. The bond yield forecasts are less forgivable, though. After all, the bond bull market lasted four decades, and depending on whether you count the brief brush with a technical bear market that played out in Q1 2021, it’s still going.

Given the tendency for 10-year yields to disappoint Wall Street’s forecasts (i.e., end the year lower), you’d be forgiven for suggesting that 2022’s early selloff will ultimately abate. Relatedly, you can perhaps understand why, after meeting so little success over the years, strategists are reluctant to mark up their year-end targets just a week in.

In a note dated January 6, Goldman’s rates team admitted that “a series of developments have led us to rethink risks” around their last round of US yield forecast revisions, released in early November. “These developments are mostly central bank-related,” Praveen Korapaty and William Marshall wrote. You’ll recall that the bank brought forward their liftoff call to March a month ago, and expects balance sheet runoff to commence later this year.

Although Korapaty and Marshall did raise their forecast for two-year yields materially (by 20bps), they left their year-end projections for fives, 10s and 30s unchanged at 1.8%, 2.0% and 2.25%, respectively. Needless to say, 2% on 10s seems eminently more achievable now than it did when the curtain closed on 2021 (figure below).

Goldman cited the market’s hesitation to price a higher terminal rate for their reluctance to raise targets beyond the two-year sector.

The bank offered two explanations for that hesitation. They prefer a supply-demand story centered on a shortage of safe fixed income assets juxtaposed with elevated savings, rebalancing needs and “immunization flows.”

“While we expect this imbalance to dissipate over time, both on account of a higher policy rate eventually making FX-hedged yield pick-ups on UST levels unattractive and a changing balance as central banks globally begin to trim their balance sheets, we estimate the supply/demand picture will not change materially until next year,” Korapaty and Marshall wrote, adding that “the persistent imbalance should keep longer maturity yields low, which in turn are likely working as a cap on terminal rates.”

They went on to detail the implications for the curve, but perhaps the most notable bit considering last week’s mammoth surge in real yields, was the commentary on the makeup of rate rise at the long-end. “We think the repricing will be mostly real yield led,” the bank wrote. Out of the ~30bps increase Goldman expects in 10-year yields over the course of 2022, Korapaty and Marshall said “15-20bps should occur in 10-year real yields,” leaving them around -0.7%. 10-year reals were at -0.72% on Friday. So, we’re already there.

What I’d note is that it seems highly unlikely the Fed would be willing to stomach the kind of risk asset tumult that would almost surely accompany a trek out of negative territory for 10-year reals, which Goldman sees staying “firmly” below zero for 2022.

Given that (and notwithstanding my steadfast contention that the longer extreme monetary accommodation remains in place, the lower the threshold for incremental tightening to prompt dramatic re-pricings across assets), it’s hard to see a scenario where financial conditions become truly restrictive.

As BofA noted late last week, “the bubble in long duration tech, crypto [and] leverage assets is simultaneously popping,” with the Hang Seng Tech index cut in half from last February’s highs, the Cathie Wood complex down ~40%, and so on. We saw the exact same thing play out in Q1 last year. In other words, some of the froth has already come off. Again. Under the proverbial hood, the market has been a semblance of efficient, even as benchmarks scaled new heights. BofA’s Bull & Bear Indicator sits at just 3.3.

As for crypto, I’m not convinced “true believers” (so to speak) care all that much about real yields. I’ve never heard an ardent Bitcoin adherent suggest the bull case is based primarily on crypto as an inverse real yields play. Of course, that’s doubtlessly part of the bull case for recent converts accustomed to operating in traditional assets (like me). So, the question becomes one of estimating how much needs to come off in order to bring Bitcoin and Ether back to levels where those converts are shaken out, leverage is lower and what’s left are mostly “believers.” I have no idea how to estimate that.

Coming back to Goldman, the bank added a few caveats to their US rates update. After reiterating that they don’t “see the conditions as yet for markets to re-evaluate longer term rates materially,” Korapaty and Marshall wrote that “one risk to this view is global central banks run off their balance sheets or end asset purchases at a much faster rate than we currently anticipate.”